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Jerome Powell was trying to save face. In November 2021, the Federal Reserve chairman was scrambling to redefine his public messaging on inflation, which had turned from a short-term pain, or in his words “transitory,” into a much bigger crisis.
“I think the word ‘transitory’ has different meanings to different people,” he said. “We tend to use it to mean that it won’t leave a permanent mark in the form of higher inflation. I think it’s probably a good time to retire that word.”
In the 14 months since that testimony, Powell and the Fed have been on an aggressive mission to rein in prices — and reestablish their credibility as managers of the US economy. But just as their efforts have begun to produce signs of progress, Powell and the Fed face a new risk: going too far.
The Fed’s ideal scenario in the months ahead is to orchestrate a so-called “soft landing,” where inflation comes back down to their target level without causing a corresponding surge in unemployment or even a recession. But in order to achieve this outcome, many experts believe Powell and the Fed need to pause their aggressive interest-rate hikes.
So far, however, there is no sign that the Fed is going to hit the brakes in a meaningful way. Powell has emphasized his willingness to cause short-term economic pain to bring down inflation, and economists at several major Wall Street banks believe that the Fed’s commitment to interest-rate hikes means recession is now the most likely outcome in 2023.
This obsession with controlling inflation — and potentially causing serious pain for average Americans — is driven by one major factor: legacy. While downturns and recessions are seen as part of the normal business cycle, letting inflation become ingrained in the economy is a once-in-a-generation sin that can stain the reputation of a central banker in the history books. Joseph E. Gagnon, a senior fellow at the Peterson Institute for International Economics and a former Federal Reserve Board associate director, told me that Powell is willing to do everything he can to avoid becoming known as the central banker that let inflation get away.
“Powell doesn’t want his name to go down in infamy,” he said.
The opportunity for a soft-landing scenario is still on the table, but Powell’s efforts to protect his reputation in the history books could backfire — and end up pushing the US economy into an unnecessary recession.
The Fed is closing in on their goals
There is no doubt that inflation needed to be conquered. The consumer price index — the most widely watched measure of inflation — peaked at 9.1% in June, the highest level since 1981. High inflation eats away at consumers’ purchasing power, and persistent inflation seeps into expectations for price and wage adjustments, which further fuel inflation. So to tackle the inflation problem, Powell led the Fed on an all-out assault on high prices, raising the central bank’s key interest rate from 0% in March 2022 to 4.5% as of December, a pace of hikes not seen in three decades. By raising interest rates, the Fed makes it more expensive to borrow money. This, in turn, slows down demand for houses, cars, and other goods by making mortgages, auto loans, and credit-card debt more costly. And as demand falls, businesses are forced to lower or hold their prices steady to attract new customers — in theory, halting the upward spiral of inflation.
That inflation-fighting effort seems to be paying off. The latest CPI report showed that prices rose by 6.5% in December compared to the year before, and prices actually fell by 0.1% from the previous month. Prices for many major goods are increasing at a slower rate, and, in some cases, have started to decline. Supply-chain issues, which resulted in high shipping costs and long delivery times that pushed prices up, are also easing. While inflation is far from the Fed’s 2% target, there are signs the cooling will continue, indicating the Fed is not far from their goal.
Peter Essele, the head of portfolio management at Commonwealth Financial Network, pointed out in a recent chart that if month-over-month inflation continues to decline at a rate of 0.1%, the CPI would be below 3% by April and below 2% by May. And even if prices increase by 0.3% a month, CPI would still be below 3% by June, he noted. David Kelly, J.P. Morgan Asset Management’s chief global strategist, recently told Bloomberg that the Fed has accomplished its inflation goals: “This is a war that they’ve won.”
What’s more, the full impact of the Fed’s rate hikes have yet to hit. Ian Shepherdson, the founder of Pantheon Macroeconomics, said in a note to clients last week that the three-month annualized measure of core inflation — inflation minus food and energy, and what the Fed pays attention to the most — is at its lowest levels since early January 2021, before inflation really started flaring up, and will continue to fall.
“And this, remember, is long before the full effect of the Fed’s tightening in the second half of last year has worked through the real economy and into the inflation numbers,” he said.
Even after being subjected to the Fed’s interest-rate battering ram, the US economy is still in one piece. The unemployment rate is at a historic low of 3.5%, job gains remain solid, and consumer spending is still positive. But cracks are starting to show in places like manufacturing, financial markets, and consumer sentiment.
Given the combination, many economists and experts have argued that instead of continuing to hike interest rates, the Fed should pause and allow the economy to adjust to their moves before determining the next step. “It is time to stop raising rates,” the University of Pennsylvania economist Jeremy Siegel said in mid-January.
Economic history 101 with Professor Powell
Despite the encouraging inflation news and the resilience of the economy, the chances of a soft landing will ultimately come down to one thing: Powell’s view of his place in history. The current bout of inflation has drawn many comparisons to the sustained price surges of the 1970s and 1980s, when the CPI rose as high as 14.5%. Arthur Burns, the Fed chairman from 1970 to 1978, is often blamed for letting inflation run so hot, bending to political pressure to keep interest rates low, which allowed crippling inflation to stick around for nearly a decade. It was only after his successor, Paul Volcker, went on a stunning three-year fight against inflation — increasing the Fed’s main interest rates as high as 19% — that prices were finally tamed. Given the parallels, it’s clear that Powell is trying to avoid going down in history as the one who let the economy spin out of control.
“I think he feels very strongly that he absolutely has to get inflation down, and nothing will stop him from doing that,” Gagnon, of the Peterson Institute, told me. “He doesn’t want to go down in history as another Arthur Burns or the other Fed chairs who allowed inflation to gradually rise and never really controlled it in the ’60s and ’70s.”
Barry Gill, the head of investments at UBS Asset Management, also suggested that the Fed will not pause its fight against inflation — much less pivot to supporting the economy with interest-rate cuts — because of Powell’s eye for history.
“My personal view is the market is being overly optimistic on the prospect of rate cuts, because I do think that the central bank’s inflation-fighting credibility is at stake here, and every Fed governor or US central banker will have thought of the plight of Art Burns and being hostage to the moment,” Gill said. “And what happened in the 1970s, nobody wants to be associated with that.”
And as much as Powell does not want to end up with a historic reputation like Burns, he has also long admired Volcker, even going so far as to crib some of the former Fed chairman’s phrasing in recent speeches. And some experts believe Powell’s focus on the real economy, even at the expense of the stock and bond markets, is a close parallel to Volcker’s. Volcker “was never a fan of Wall Street — he didn’t give a damn what his policies did to investors,” said Danielle DiMartino Booth, a former advisor at the Federal Reserve Bank of Dallas. “That is the characteristic of Paul Volcker that I think Jay Powell is trying to emulate,” she told me.
This admiration for the inflation-slaying former Fed chairman has shown up in Powell’s frank diagnosis of what it will take to rein in soaring prices. “I wish there were a completely painless way to restore price stability — there isn’t,” he said at a press conference in December, after the Fed once again raised interest rates, and he forecasted that there were more on the horizon.
While history may look back favorably on Powell if he manages to control inflation, many experts and economists believe that too much emphasis on fighting the inflation battles of the past could end up defining Powell’s legacy in a different way.
Powell’s legacy versus the economy
While economists and historians will litigate Powell’s reputation for years to come, most experts agree that a continued upward drive in interest rates will cause severe pain for American workers and the stock market alike.
Cam Harvey, a professor at Duke University and the director of research at the investment firm Research Affiliates, told me that continued rate hikes won’t be able to address the price pressures that remain in the economy — most of which, he argued, are caused by idiosyncratic disruptions that the Fed can’t fix.
“We know that many of the inflation issues are supply issues, and there could be policy initiatives — and I know the Fed doesn’t make policy, but they can certainly inform it,” Harvey told me in December. “There could be many things that we could do to mitigate the actual source of inflation, rather than this blunt instrument that just drives us into recession.”
He added: “I think it’s counterproductive for the Fed to continue to be aggressive in increasing rates. So at this point, I would just pause.”
Rob Arnott, the legendary investor who founded Research Affiliates, pointed to the inverted yield curve — a bond-market signal that has preceded every recession since the 1960s and was first discovered by Harvey — as a clear sign that the Fed is driving the US economy directly into a mess. “They should pause now,” he told me. “They’ve got it inverted.”
Any Fed-driven recession, even a so-called “mild” one that some economists have predicted, would have devastating consequences for millions of Americans. Bank of America economists expect that the US economy will begin to lose 175,000 jobs a month early this year. The Fed itself sees unemployment rising to 4.6% in 2023, meaning 1.8 million Americans would lose their jobs this year, while economists at the International Monetary Fund projected that the rate could top 7%.
Stocks would also suffer, according to Wall Street strategists. David Kostin, Goldman Sachs’ chief US equity strategist, said a recession would send the S&P 500 plunging another 22%. Morgan Stanley’s Mike Wilson, meanwhile, sees a potential slide of as much as 26%. Such a sell-off would particularly hurt those looking to retire in the months and years ahead, as many portfolios would lose significant value.
Ken Rogoff, a former chief economist at the International Monetary Fund and a professor at Harvard University, told me that the Fed should stomach somewhat higher inflation, even if it doesn’t get all the way back to their 2% goal immediately, in exchange for not sparking a recession. While he said a soft-landing scenario would be difficult to engineer, it could still happen over a longer timeline.
Not everyone agrees that this trade-off is worth it, however. Savita Subramanian, the head of US equity, quantitative, and ESG strategy at Bank of America, believes the Fed’s aggressive tightening is warranted in order to control high inflation, and argued that the extraordinary amount of stimulus that Americans received during the pandemic is helping prop up inflation for longer, forcing the Fed to act more emphatically. “I think that the Fed’s doing what they have to do,” she told me.
These trade-offs leave Powell in a tough spot: Massive job losses and high unemployment could certainly take some shine off his legacy, but pretty much every Fed chairman has had to deal with a recession or a downturn in their term. Over the past 50 years, only a handful have allowed inflation to run out of control.
There are signs that certain Fed officials are ready to dial back on the inflation fight. Two members of the 19 officials who serve on the Federal Open Market Committee, the panel that officially votes on interest-rate policy, have said the Fed should hike its main interest rate by just a half-percentage point in 2023 — from 4.5% to 5%. Other members want to hike the rate higher. But in the end, just how far the Fed pushes things will almost certainly rest on Powell’s shoulders.
Inflation left unchecked is a scourge on economies. But given how aggressively the Fed has tightened, the significant progress already made on inflation, and the dire consequences at stake for jobs and investment portfolios, the Fed might do well to take the opportunity for a soft landing while they still have it. And navigating such a tricky economy — without throwing hundreds of thousands of Americans out of work — could cement Powell’s legacy.
William Edwards is a senior investing reporter at Insider.